For a federal employee, contributing to the traditional Thrift Savings Plan (TSP) and to a traditional IRA are highly recommended for the purpose of increasing the employee’s future retirement “nest egg”.
An employee who contributes to the traditional TSP and an employee who contributes to a deductible traditional IRA uses before-taxed dollars to contribute, receiving a current year tax deduction at a time the employee is likely in a higher marginal tax bracket. The idea is to defer paying taxes on these before-taxed TSP and IRA contributions and accrued earnings until the individual is retired, no longer earning a paycheck, and potentially in a lower marginal tax bracket. The benefit of tax-deferred growth on a traditional IRA and traditional TSP account supercharges the growth in these accounts.
But this strategy assumes that when the traditional TSP and IRA accounts are withdrawn during the retirement years, the traditional TSP participant and traditional IRA owner are in fact in a lower marginal tax bracket. This is not always the case that an individual will be a lower marginal tax bracket in retirement. In fact, given today’s reduced individual federal marginal tax rates, a retirement saver today may be in a higher individual federal marginal tax bracket in retirement compared to the tax bracket when the individual saver contributed to the traditional TSP and/or traditional IRA.
This column explains why many federal employees could likely be in a higher marginal tax bracket by the time they withdraw their traditional TSP and traditional IRA accounts.
That being said, a traditional IRA conversion to a Roth IRA and/or a transfer of the traditional TSP to a Roth IRA makes sense during these years for those employees who will likely be in a higher marginal federal tax bracket in retirement. Note that when a deductible traditional IRA (a traditional IRA in which the contribution was deducted on one’s federal income tax return as an adjustment to income) is converted to a Roth IRA, the traditional IRA owner will pay income taxes at his or her current year marginal tax bracket. This is also true when part of the traditional TSP is transferred to a Roth IRA. But once the converted or transferred traditional TSP and IRA accounts are in the Roth IRA, the accounts will grow tax-free and will be withdrawn tax-free.
Why Federal Marginal Tax Rates May Be Higher in Retirement for Many Federal Employees
The Tax Cuts and Jobs Act of 2017 (TCJA) lowered individual tax rates, but only for the period of Jan. 1, 2018 through Dec. 31, 2025. Unless Congress acts, the TCJA individual tax rate cuts will expire on Dec. 31, 2025. Effective Jan. 1, 2026, tax rates will revert back to the 2017 tax rates, inflation adjusted. The following two charts compare the current 2019 individual tax rates to the 2017 tax rates. The 2019 individual tax rates and the 2017 individual tax rates are presented in the tables below.
Given that rates will likely increase effective Jan. 1, 2026 unless Congress changes the law, this means that individuals now have this six-year window (2020-2025) to take advantage of the current lower brackets, converting traditional IRAs, and/or transferring a portion of their traditional TSP to a more tax-advantaged Roth IRA.
Starting at age 70.5 and every year thereafter, a retired federal employee must receive a required minimum distribution (RMD) from his or her TSP account. Each year the RMD is based on the TSP account balance as of the last day of the previous year and the TSP participant’s current year life expectancy.
Many traditional TSP participants who are in their late 60’s have TSP balances exceeding $1 million. At age 70.5, the RMDs for these participants could be into the five-figure amounts and, when added to an annuitant’s other taxable income (CSRS or FERS annuity, Social Security, traditional IRA RMDs and perhaps other qualified retirement plan RMDs), could push an annuitant into a federal higher marginal tax bracket.
With some planning, a traditional TSP participant can reduce his or her traditional TSP balance by transferring portions of their traditional TSP account to a Roth IRA.
Note that employees over age 59.5 and annuitants are permitted to make multiple transfers of traditional TSP to Roth IRAs under the new TSP withdrawal rules that took effect in September 2019. Ideally, these transfers will be done over a period of time before the TSP participant becomes age 70.5 in order to reduce the traditional TSP balance by the time the traditional TSP participant becomes age 70.5. In so doing, the traditional TSP balances at age 70.5 and beyond will be lower, thereby decreasing the amount of TSP RMDs and perhaps keeping the annuitant in the same or lower federal marginal tax bracket.
A married federal employee will face the situation that when the first spouse dies, the surviving spouse will be left to manage the inherited money from the deceased spouse. This often results in a marginal tax bracket change (increase) for the surviving spouse. Moreover, the surviving spouse will move from the married filing joint to single tax bracket.
Typically, in the case of the surviving spouse of a federal annuitant, the spouse will be receiving the deceased spouse’s CSRS or FERS survivor annuity, as much as 50 to 55 percent of what the deceased spouse was receiving. The surviving spouse will also be eligible to receive the deceased spouse’s full Social Security and the deceased spouse’s TSP. The surviving spouse could also be receiving his or her own retirement (401(k) or TSP retirement, traditional IRAs) income. The overall result is that the surviving spouse could find himself or herself with the same income sources but in the single tax filing bracket, thereby being subject to much higher tax rates as shown in the tax tables above.
At the death of the first spouse (who was a federal annuitant), the surviving spouse will often rollover the inherited TSP money (assuming the surviving spouse was the named TSP beneficiary) into his or her own traditional IRA or, if the surviving spouse was also a federal employee and owns a TSP account into the TSP account. Once the surviving spouse reaches age 70.5, TSP and/or traditional IRA RMDs are required and are taxed at the single tax rate rather than at the married filing joint rate. That could increase the taxes due significantly. But with some planning the surviving spouse is advised to convert some of the traditional IRAs to Roth IRAs and/or to transfer some of the traditional TSP to Roth IRAs. In so doing, the traditional IRA and traditional TSP balances will be reduced, ultimately reducing the tax liability when the tax bracket later increases for reasons given above.
How Much of the Traditional IRA Should Be Converted and How Much of the Traditional TSP Should be Transferred at Any Time?
The goal is to convert a certain amount of a traditional IRA and transfer a certain amount of one’s traditional TSP to a Roth IRA in any year so as not to pay more taxes than necessary.
This means that Roth IRA conversions and traditional TSP transfers to Roth IRAs should ideally be performed over a period of years so as that in any given tax year, the traditional TSP participant and/or traditional IRA owner should not be pushed into a higher tax bracket as a result of these conversions and transfers. Here are the recommended steps for employees and annuitants to determine how much to convert and transfer between now and Dec. 31, 2019:
Step 1. Calculate approximate taxable income for 2019. That is, total income received during 2019 less the standard deduction or itemized deductions. Use the 2018 Form 1040 filed in spring 2019 as a guide.
Step 2. After determining taxable income and one’s taxable income, determine from the above 2019 tax table what marginal tax bracket one is in.
Step 3. Find the top of one’s marginal tax bracket. For example, if one is married filing jointly the top of the 22 percent tax bracket is $168,400.
Step 4. Take the taxable income amount at the top of one’s marginal tax bracket and subtract from it one’s 2019 taxable income from Step 1 above. The difference is the amount one can convert of a traditional IRA to a Roth IRA and/or transfer from the traditional TSP to a Roth IRA between now and Dec. 31, 2019 without being pushed into the next higher marginal tax bracket.
The following example illustrates:
Joseph is a federal annuitant filing married filing jointly with year-to-date taxable income of $147,500. The taxable income level at the top of the 22 percent marginal tax bracket for married filing jointly for 2019 is $168,400 (see table above). That means that Joseph has $168,400 less $147,500, or $20,900, before he goes into the 24 percent federal marginal tax bracket for 2019. Joseph could therefore transfer $20,900 of his traditional TSP to a Roth IRA during December 2019 and pay tax at a rate of 22 percent.
If Joseph is 64 years old and assuming his taxable income does not change much over the next six years, he could repeat this process until age 70.5, transferring $20,900 times six, or a total of $125,400, of his traditional TSP to a Roth IRA. That money in the Roth IRA will grow tax-free. In addition, the balance in Joseph’s traditional TSP will be $125,400 lower at age 70.5, so that his TSP RMDs will be less.
Finally, some things to keep in mind and mistakes to avoid when converting a traditional IRA to a Roth IRA and transferring traditional TSP to a Roth IRA:
- Make sure there is sufficient liquid assets (cash) available to pay the federal and state taxes due upon either a conversion or transfer to a Roth IRA.
- Make sure there is sufficient time to leave money growing tax-free in the Roth IRA in order to make up the amount paid in taxes in the year of conversion or transfer. Needless to say, this depends primarily on how fast the money is growing. A minimum of five to ten years is recommended.
- While there is no limit as to how much can be converted or transferred to a Roth IRA in any one year, it is important not to convert or transfer an amount that would result in the individual being pushed into a higher marginal tax bracket.
- The 10 percent early withdrawal penalty does not apply to Roth IRA conversions nor to the transfer of the traditional TSP to a Roth IRA.
- While Roth IRAs are not subject to RMDs when the Roth IRA owner becomes age 70.5, as is the case with traditional IRAs and traditional TSP, upon the death of the Roth IRA owner non-spousal Roth IRA beneficiaries are subject to the RMD rules based on their life expectancies. But non-spousal Roth IRA beneficiaries will receive Roth IRA proceeds tax-free when the inherited Roth IRA proceeds are disbursed. This is not the case with traditional IRAs and the traditional TSP as beneficiaries of these accounts will pay full federal and state income taxes when these accounts are disbursed.